The Fundamental Case for the 20,000 Dow

Tuesday, August 14th, 2012

by Seth Masters, Chief Investment Strategist, AllianceBernstein

While some people deem stocks expensive relative to 10-year trailing earnings, we take a forward-looking approach. It starts with the premise that the stock market is not a casino and stock prices are not pulled out of thin air: they reflect the intrinsic value of companies’ future earnings.

Let’s start with basics. Stocks represent an ownership claim on a share of company earnings. Hence, stock prices reflect (imperfectly, of course) the value of companies’ current earnings and potential earnings growth. In computing the expected returns for stocks, what matters is the starting price, earnings, dividends (the portion of earnings distributed to shareholders), earnings growth and changes in P/E. As you might expect, low starting prices, high earnings and dividends, high growth, and P/E expansion are all good for future stock returns.

The models we use when investing are complex, but a simple argument makes the point. The expected return for a Treasury bond held to maturity is equal to its yield. Similarly, the expected return for a stock equals its earnings per share (EPS) divided by its price—its earnings yield—if the company has no growth prospects and therefore returns all of its earnings to shareholders. If the company does have growth prospects, it would retain some of its earnings to fund growth. In that case, the expected return equals the dividend yield plus dividend growth. If the company pays out a constant share of earnings as dividends, dividend growth equals earnings growth.

Let’s apply this framework to the S&P 500 Index’s price level of about 1,300. Consensus forecasts call for the index to have $104 in earnings per share this year. If the companies in the index didn’t xpect any growth, they would pay out all their earnings as dividends, and earnings and dividends wouldn’t grow. The S&P 500’s dividend yield would be 8%, as the first row of the display below shows.

If the P/E remained unchanged, the total return would also be 8%, but both the S&P 500 and the Dow would stay at their current level. While a flat index price might be disappointing, we think most investors today would probably welcome an 8% return on investment.

Of course, the companies in the S&P 500 do retain a portion of their earnings to finance growth, so the index’s dividend yield is slightly above 2%, rather than 8%, as the second row of the display shows. What kind of earnings growth should we assume?

What About Growth?

Historically, earnings and the stock market have grown with the economy over time, although they can diverge for several years at a stretch, particularly if market euphoria drives stock prices to very high multiples of earnings or if gloom drives stock prices to low multiples. Nominal US GDP, which includes inflation, has grown 7% a year on average since 1947—and so have the S&P 500’s earnings and price. (GDP growth is more commonly quoted in real, or inflation-adjusted, terms. We use nominal growth here to match data for earnings growth and the stock market.)

The three key variables that drive both economic growth and earnings growth over the long term are inflation (which increases the nominal value of economic output), population growth (which boosts the number of people consuming and producing goods) and productivity (which increases the output per person or per unit of capital).

Inflation is widely expected to average about 3% over the long term; population growth, to average about 1%; and productivity, to continue to rise about 2% per year. Since 3% + 1% + 2% = 6%, 6% is a plausible long-term economic growth forecast; it is actually below both the postwar average and the International Monetary Fund’s projections for the next five years.*

So let’s assume 6% economic and earnings growth. With a constant dividend payout ratio, this would lead to 6% dividend growth. Eventually, this growth rate would probably make investors less gloomy, and the market would rise from its current low level of 12.5 times earnings.

If the S&P 500’s P/E rose to 15—halfway back to its average of 17.6 since 1970—the index’s expected return would be 9% per year. At that rate, the S&P 500 would reach 2,000 in five years. The Dow, which typically trades at about 10 times the S&P 500, would reach 20,000 in about five years.

But as discussed above, the market should arguably be trading at an above-average multiple, since bond yields are so low. If the S&P 500’s P/E rises to 20 times earnings as sustained growth in a low-interest-rate environment makes investors more confident, the Dow could reprice to 20,000 immediately, as the third row of the display shows.

Since most investors today would probably welcome an 8% or 9% return for the next five to 10 years (let alone an immediate market revaluation), the current limited appetite for stocks suggests that investors don’t believe in these scenarios. Most likely, they don’t believe in the consensus forecast of $104 in earnings per share this year or 6% economic growth. So let’s examine the implications for stock returns of lower earnings and slower economic growth.

What If Earnings Fall or GDP Growth Slows?

Many people expect earnings to decline because margins are far higher than usual. If corporate spending picks up from the unusually low levels of recent years, margins would fall, and that could drive down earnings.

We think it’s reasonable to expect margins to decline somewhat—although not necessarily to their historical average. But for the sake of argument, let’s look at what would happen if margins declined from 9.5% today to their long-term average of about 6.75%.

Even in this scenario, the S&P 500 would reach 2,000 and the Dow would reach 20,000 in about 10 years. Applied to current revenues, 6.75% margins would reduce S&P 500 earnings by about 30%—to $74, as the fourth row of the display shows.

While there would likely be a severe market pullback initially, if normal economic growth resumed and P/E ratios normalized, the S&P 500 would have a 5% total return and reach 2,000 in 10 years.

But the global economy is now weak, and the European sovereign-debt crisis could end up being a drag on economic growth for years. What if Europe and theUSenter a lengthy period of disinflation? That’s possible, particularly if policymakers are unsuccessful at addressing the world’s serious macroeconomic problems.

So let’s perform a stress test and assume inflation of only 1%, population growth of 1% and no productivity growth at all. That would give us nominal GDP growth of just 2%. A recent survey of professional forecasters said there’s less than a 10% chance that economic growth will be that slow over the next three years.**

What would these dismal economic forecasts imply about future earnings growth and stock returns? If we assume the S&P 500 earns $74 per share this year, 2% growth would still get us to a 4% annualized market return if the market P/E ultimately returns to average, as the fifth row of the display shows. At that rate, it would take 20 years for the S&P 500 to reach 2,000 and the Dow to reach 20,000. Such returns are hardly enticing, but they are still likely to exceed bonds.

Of course, stock-market returns could be worse than 8% (or 4%), particularly in the short term. S&P 500 earnings could fall below $74, and anxiety could cause market valuations to drop even further below normal; both happened in early 2009. Other market shocks are also possible. For example, very high inflation with slow growth could cause price-to-earnings multiples to contract.

But market returns could also be better. Our stress test incorporated draconian assumptions—a 30% drop in earnings plus no productivity growth at all, a very rare occurrence over a 10-year period. Human ingenuity has led to remarkably persistent and steady productivity growth in the postwar period. In recent years, new technology and globalization have driven productivity growth. In the future, these trends and others not yet imagined are likely to continue to drive it.

Faced with uncertainty and traumatized by losses in recent years, investors who are avoiding stocks appear to be assuming that the worst outcomes are highly likely to occur. Or, perhaps, they’ve just lost their stomach for market volatility and are prizing near-term stability over potential long-term gains.

In my next post, I will compare the likely range of outcomes for stocks and bonds.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Seth J. Masters is Chief Investment Officer for Asset Allocation at AllianceBernstein and Chief Investment Officer of Bernstein Global Wealth Management, a unit of AllianceBernstein.

Tags: Alliancebernstein, Chief Investment Strategist, Company Earnings, Consensus Forecasts, Dividend Growth, Dividend Yield, Dividends, Earnings Growth, Earnings Per Share, Future Stock, Growth Prospects, Intrinsic Value, Premise, Price Earnings, Shareholders, Stock Market, Stock Prices, Stock Returns, Thin Air, Treasury Bond
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Emerging Markets Radar (August 13, 2012)

Saturday, August 11th, 2012

Emerging Markets Radar (August 13, 2012)

Strengths

• Chinese President Hu Jintao presided over a Central Politburo meeting on July 26. He reaffirmed maintaining stable growth as the top priority and pledged to increase policy support for the real economy. The frequent economic meetings hosted by the president and premier in late July suggest a higher probability for more follow-up measures soon to stabilize growth.
• China’s new bank lending may be about Rmb 700 billion in July, Economic Information Daily reports, showing gradual increase of money supply.
• The Ministry of Railway announced that it plans to spend Rmb 470 billion on railroads and bridges this year.
• Money supply in Association of Southeast Asian Nations (ASEAN) countries is robust, driven by infrastructure and property, and consumer spending. Singapore total domestic banking loans shows 20.9 percent growth year-to-date by the end of June, while it is 12.6 percent for Malaysia, 26.2 percent in Indonesia, 14.6 percent in Thailand and 14.7 percent for Philippines.
• Singapore’s unemployment rate fell in the second quarter to 2 percent from 2.1 percent the previous three months.

Weaknesses

• China’s Purchasing Manager’s Index (PMI), China’s official gauge of manufacturing activities, declined by 10 basis points from 50.2 in June to 50.1 in July. It is lower than market consensus of 50.5.
• Taiwan’s second-quarter GDP was down 0.16 percent, versus the estimate of 0.5 percent.
• Korea’s industrial production rose 1.6 percent in June, missing expectation for a 1.8 percent increase and down from May’s 2.6 percent.
• Thailand’s exports fell 4.3 percent in June while imports rose 5 percent, further demonstrating robust domestic demand in the country. Companies that are selling to world markets are in general seeing sales earnings growth slow down, while those that sell to domestic demand are still seeing robust growth, such as telecom, utilities and property. The same happens to China and other ASEAN countries.
• Hong Kong June trade growth missed expectations. Exports were down 4 percent year-over-year and imports were down 2.9 percent.
• Korea’s second-quarter GDP expanded 2.4 percent, growing at the slowest pace in almost three years, below median estimate for a 2.5 percent gain.
• China’s Xi’an city said it would limit vehicle ownership to control traffic congestion.

Opportunities

• The recent strong support for the European project voiced by both the ECB and the German political establishment provides significant tail risk of increased forms of monetary policy support in the coming weeks.
• After the surprise July rate cut in South Africa, the market is pricing in a 25 percent chance that the Monetary Policy Committee will follow up with a further 50 basis point cut by year-end. Monetary policy is already very accommodative, and the policy rate is at multi-decade lows.
• Already representing 17.5 percent of the world’s population, India is projected to surpass China to be the most populous country in the world by the year 2025. With more than 65 percent of its population below the age of 35, it is expected that in the year 2020, the average age of an Indian will be 29 years, compared to 37 years for China.
• The dividend yield of telecommunications companies in Asia ex-Japan are close to 5 percent on average. The dividends are sustainable due to high free cash flow yield. This compares favorably with the 10-year treasury which yields less than 2 percent.

Threats

• Investors have heard many times from the Chinese government that it is committed to secure economic growth, but its actions are still behind the curve. Particularly, its inability to find a balanced property policy will affect the growth of the economy.
• High household debt burden, reduced consumer purchasing power and a relatively weak domestic growth outlook bode ill for banking sector growth in Brazil. Existing banking sector stress is likely to grow over the coming quarters on the back of declining interest rates and deteriorating asset quality.
• The Czech central bank forecast GDP will contract 0.9 percent in 2012, as measures to curb the budget deficit damp domestic demand.  The economy relies on demand for cars, auto parts and electronics from the EU, which buys about 80 percent of Czech exports.

Tags: Asean Countries, Association Of Southeast Asian Nations, Brazil, Chinese President Hu, Chinese President Hu Jintao, Earnings Growth, Economic Information, Hu Jintao, India, Market Consensus, Money Supply, Politburo, President Hu Jintao, Purchasing Manager, Quarter Gdp, Robust Growth, S Industrial, Southeast Asian Nations, Stable Growth, Telecom Utilities, Top Priority, Unemployment Rate
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Ray Dalio’s Bridgewater On The “Self Re-Inforcing Global Decline”

Thursday, July 19th, 2012

The world’s largest hedge fund is not as sanguine about the hope that remains in the markets today. The firm’s founder, Ray Dalio, who has written extensively on the good, bad, and ugly of deleveragings, sounds a rather concerned note in his latest quarterly letter to investors as the “developed world remains mired in the deleveraging phase of the long-term debt cycle” and has spread to the emerging world “through diminished capital flows which have weakened their growth rates and undermined asset prices”. Between China, Europe, and the US, which he discusses in detail, he sees the lack of global private sector credit creation leaving the world’s economies highly reliant on government support through monetary and fiscal stimulation. The breadth of this slowdown creates a dangerous dynamic because, given the inter-connectedness of economies and capital flows, one country’s decline tends to reinforce another’s, making a self-reinforcing global decline more likely and a reversal more difficult to produce. After discounting a relatively imminent return to normalcy in early 2011, markets are now pricing in a meaningful deleveraging for an extended period of time, including negative real earnings growth, negative real yields, high defaults and sustained lower levels of commodity prices. Lastly he believes the common-wisdom – that the Germans and the ECB will save the day – is misplaced.

Bridgewater Q2 Letter: Outlook and Markets Discussion

by Ray Dalio, Bridgewater Associates

The developed world remains mired in the deleveraging phase of the long-term debt cycle. The European deleveraging has been badly managed and is escalating, bringing Europe closer to either a debt implosion or a monetization and currency collapse. The impact of the European deleveraging has spread to the emerging world through diminished capital flows which have weakened their growth rates and undermined their asset prices. In the US, the deleveraging is progressing in a more orderly fashion but continues to weigh on the economy’s ability to grow without the monetary support of the Fed. Our studies of deleveragings have proven to be invaluable through this period (let us know if you would like a copy of the expanding library). Because the dynamics of deleveragings are understandable and observable throughout history, one can reasonably assess the nature of their outcomes over time. But because highly-indebted systems that are in deleveragings are also inherently unstable, the timing of discrete events is always highly uncertain (e.g., the shift from austerity to monetization, an exit from the euro, etc.). Through these studies we have continued to refine the indicators we use to measure how the forces of deleveraging are impacting various economies and markets, and we continue to make the relevant adjustments to our investment process that both allow us to anticipate these shifts and to control our risks through the unpredictable twists and turns.

At this point in time Europe is in the most critical stage of the deleveraging process, without a credible plan that will allow a transition from an “ugly” deleveraging, where incomes fall faster than debts decline, to a “beautiful” one, where income grows faster than debts. A transition from an “ugly” to a “beautiful” deleveraging requires an acceptable mix of default, redistribution and monetization. Steps have been taken in this direction, but they remain well short of what is necessary. The range of potential outcomes for Europe and the impacts on the global financial system are wide, so navigating this environment will require flexibility and an understanding of how new policy decisions will affect the path of the deleveraging.

The unresolved European imbalances and the differences in their impacts on each country have produced widening differences in the self-interests of these countries, which have led to political divergences that have magnified the risks. Unlike a year ago, Germany and France no longer stand in solidarity as backstops behind the euro system, but have been divided in their self-interest by divergent financial conditions which are leading to conflicting rather than unified political orientations. France’s deteriorating finances and economy have shifted its self-interest toward alliances with “recipient” (lower credit rated) countries like Italy and Spain and away from “contributor” (higher credit rated) countries like Germany and the Netherlands, leaving Germany more isolated as a guarantor of the risks in the euro system and in its views about how to manage the imbalances. Given these shifts in the alliances between contributor and recipient countries we think that the popular assumption that the Germans and the ECB (which requires agreement of the key factions within it) will come through with money to make all of these debts good should not be taken for granted. Said differently, we think that there are good reasons to doubt that European bank and sovereign deleveragings will be prevented from progressing to the next stage in a disorderly way, without a viable Plan B in place. This fat tail event must be considered a significant possibility.

Given the lack of global private sector credit creation, the world’s economies remain highly reliant on government support through monetary and fiscal stimulation. Now that the most recent round of global monetary stimulation has ended, world economic growth has slowed and central bankers are in the process of stimulating again. We estimate that in the past few months, global growth has slowed from about 3.3% to 1.9% and that 80% of the world’s economies have slowed, including all of the largest. The breadth of this slowdown creates a dangerous dynamic because, given the inter-connectedness of economies and capital flows, one country’s decline tends to reinforce another’s, making a self-reinforcing global decline more likely and a reversal more difficult to produce. And at this point, while actions have been taken, none of the world’s largest economies are stimulating aggressively via either monetary or fiscal policy, further reducing the odds of a reversal.

About half of the global slowdown has been due to slower growth in China. In recent years, China has been the locomotive of world growth and its recent sharp slowdown has had knock-on impacts on numerous countries and markets. China itself now makes up 12% of world GDP and its interactions with the rest of the world add to its impact. China is a large export destination for many countries and is the largest marginal consumer of raw materials in the world, so its slowdown has disproportionately hurt the economies which export to China, and its weaker commodity consumption has hurt the commodity producers. In response to this slowdown, China has begun to ease monetary policy and is contemplating more aggressive fiscal stimulation, but the actions have so far been gradual and have not yet been sufficient to produce a notable economic response.

US conditions have slipped with the rest of the world and the Fed has decided to extend its Twist operation; to end it would have been an inappropriate tightening. Last year’s hump in growth has passed as numerous temporary forces have faded, and private sector credit growth remains weak, so growth is converging on the growth of income of around 1.5%. Besides the drag from Europe and the potential for a contagious debt blowup there, numerous US federal programs will expire in the fourth quarter, and given the likely political divisions after the election it will be a challenge for the new Congress to deal with these in a timely manner. Without action, the expiration of these programs represents a fiscal drag on growth of about 2.5%. Given the lack of new aggressive Fed stimulation, the threat from Europe, the simultaneous decline in major country growth rates and the fiscal cliff, the risks to US growth are skewed to the downside.

Over the past 18 months what markets are discounting has changed radically, with a clear bias toward discounting much weaker growth for a longer period of time. This shift is reflected in the rise in credit spreads, fall in bond yields, much lower discounted future earnings growth, flattening of the yield curve, currency moves and shifts in commodity prices. But such price changes simply reflect a transition from the discounting of one set of future economic conditions to the discounting of another set of future economic conditions. After discounting a relatively imminent return to normalcy in early 2011, markets are now pricing in a meaningful deleveraging for an extended period of time, including negative real earnings growth, negative real yields, high defaults and sustained lower levels of commodity prices. This pricing is the midpoint of discounted expectations and each market has an equal probability of outperforming or underperforming. By balancing the portfolio’s exposure to discounted growth and inflation, a disappointment in one asset class will be offset by gains in another, without the necessity of predicting which it will be.

Tags: Asset Prices, Bridgewater Associates, Capital Flows, Commodity Prices, Connectedness, Credit Creation, Currency Collapse, Debt Cycle, Earnings Growth, ECB, Global Decline, Government Support, Hedge Fund, Imminent Return, Implosion, Monetization, Quarterly Letter, Ray Dalio, Return To Normalcy, Term Debt
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Could “Confidence” Add 50 Percent to the Stock Market?

Wednesday, July 11th, 2012

Could “Confidence” Add 50 Percent to the Stock Market?

by James Paulsen, Chief Investment Strategist, Wells Capital Management

Fear (a lack of confidence) has dominated the economic and investment climate since the 2008 crisis. Indeed, excessive fears during the crisis likely accentuated the magnitude of the economic collapse far more than did poor economic fundamentals alone. Similarly, the inability to revitalize confidence since has also hampered both the economic and stock market recoveries.

A culture devoid of confidence has proved a chronic liability during the last five years. However, could a slow but steady revival in confidence soon become a primary asset driving stock prices higher? For a third time in the post-war era, since 2008, the U.S. stock market has traded below its long-term trendline level (that is, the level of the stock market if it rose through time at a constant pace equal to its long-term average return). While the slope of the stock market’s trendline tends to approximate the sustainable earnings growth rate, the degree to which the stock market trades above or below its trendline level has depended primarily on economic confidence. As shown below, should confidence simply rebound to a normal recovery level in the next several years, the return of the U.S. stock market may be boosted by 50 percent!

Post-War U.S. Stock Market vs. Trendline

Charts 1 and 2 compare both the U.S. stock market and U.S. corporate earnings relative to their respective post-war trendline levels. In each case, the trendlines are calculated by a simple regression of the (natural log) level of the stock market or profits against time. The slope of each trendline is a proxy for the average annualized growth rate over the entire period. Not surprisingly, since stock prices respond to earnings, the trendline slope of corporate profits and of the U.S. stock market are nearly identical at about 7 percent. And, 7 percent is very close to the annualized growth in nominal GDP—since 1949, nominal GDP growth has averaged about 6.7 percent overall. Essentially, over long periods of time, earnings cannot grow faster than overall economic growth and the buy and hold price only return from the stock market approximates the long-term pace of earnings growth.

Is Historic Earnings Trendline a Good Guide to Future?

In the post-war era, the annualized total return from stocks has been about 11 percent comprised by about 7 percent earnings growth and about 4 percent dividend returns. As shown in Chart 1, however, in the last decade, the stock market has significantly trailed relative to its trendline. Is the old trendline growth rate of about 7 percent still a reasonable expectation for the future?

Certainly, U.S. balance sheets are more leveraged today and the savings rate has been far lower in recent years compared to earlier in the post-war era. Moreover, aging U.S. demographics almost ensures slower labor force growth in future years (a moderating force for overall economic growth) unless immigration policy is considerably liberalized. Alternatively, in the last couple decades, the global economy has created a fabulous new economic growth booster—functioning emerging world economies! So far, these new economic entities have mainly augmented supply capabilities but several are on the cusp of becoming burgeoning middle class economies which should dramatically boost global demand and perhaps help maintain global economic growth rates even as developed economies age.

Most encouragingly, however, as shown in Chart 2, U.S. earnings continue to follow the long-term trendline established throughout the post-war era. Despite noticeably slower average GDP growth in the U.S. since 1985, earnings growth has continued to approximate its historic long-term trendline. Indeed, despite the pronounced and ongoing concerns surrounding the contemporary recovery, U.S. earnings bounced quickly above trendline after the recession and have since risen in line with trendline growth. Overall, earnings show no signs yet of breaking below long-term results suggesting the long-term trendline for the stock market may remain near post-war norms.

The Valuation of the Earnings Trend

Although stocks are ultimately tethered to earnings, in the short-run, the stock market often trades at a premium or discount to its trendline. As illustrated in Chart 1, the difference between the stock market and its long-term trendline is a good proxy for investors’ valuation of the long-term earnings trend. Since 2008, for the third time in post-war history, the U.S. stock market has traded persistently “below” its trendline. This also occurred after WWII until the mid 1950s, and again between the early 1970s until the late 1980s.

This is also illustrated in Chart 3. What causes investors to value the earnings trend sometimes at a 25 percent (or more) premium and sometimes at a 25 percent (or larger) discount? Certainly, multiple factors comprise this complicated valuation. During the late 1940s, the discount to trendline seemed to be driven by a post-war inflation surge, in the 1970s escalating inflation and interest rates appeared to lower valuations, and in the contemporary period persistent anxieties surrounding the potential for a global financial calamity have dominated. By contrast, the huge premium paid by investors for trendline earnings in the 1960s coincided with attitudes reflected in the “Camelot Kennedy Years” while the record-setting premium valuation reached in the late 1990s was a product of a “new-era” mania.

Confidence & Valuations

As shown in Chart 4, the discount or premium valuation of the stock market relative to its trendline is perhaps best explained by economic “confidence.” This chart overlays the percentage differential of the stock market relative to its trendline with the consumer confidence index. Although not a perfect relationship, the level of confidence has done a good job tracing changes in the “valuation of the earnings trend” during the post-war era.

Since at least 1950, premium and discount valuations of the stock market to its trendline have corresponded closely with periods of strong economic confidence and periods of broad economic fear. Currently, U.S. economic confidence is hovering in the lowest quartile of its post-war range and the U.S. stock market is about 25 percent below its trendline. This is not a coincidence. As was the case in the late 1940s, early 1950s, and again in the 1970s, early 1980s, a slow but steady revival in U.S. confidence could represent the biggest driver of stock market performance in the next several years!

An Investment Possibility?

The confidence index illustrated in Chart 4 has oscillated between about 60 and 110. With the exception of the late 1990s when the index briefly reached above 110, “normal” economic recovery confidence peaks have been around 100. Stock investors should consider what could happen should confidence slowly recover to normal again in the next five years eventually reaching a level between 95 and 100. Using history as a guide (reading across to the left scale in Chart 4), if confidence returns to normal, the stock market would likely trade at a 25 percent to 30 percent premium to its trendline level.

Of course, in five years, the stock market trendline level will also be higher. If the historic trendline growth rate remains a good guide for the future, the trendline (the dotted line) in Chart 1 would rise by about 7 percent a year in the next five years suggesting a trendline by 2017 of about 2425. However, to be conservative, assume in the next five years trendline earnings only grow at a pace of 3 percent, significantly “less” than the long-term trendline growth rate of 7 percent. Currently, the S&P 500 trades at about 1350 and its trendline level (from Chart 1) is about 1800 (i.e., 25 percent higher than the S&P 500 current price of 1350). With these assumptions, the stock market trendline would rise by 16 percent in five years to about 2100!

Finally, from Chart 4, assume confidence improves from its current level to about 95 boosting the investor valuation of the trendline from its current 25 percent discount to about a 25 percent premium in five years. A trendline target in five years of about 2100, combined with a valuation premium of about 25 percent implies a target price for the S&P 500 of about 2600—nearly a double from today’s level!

Summary

While we are not forecasting a doubling of the stock market during the next five years, this analysis does highlight the longer-term upside potential from stocks which exist today solely because of widespread cultural fears. Chart 3 shows the stock market has a historical tendency to oscillate between periods of glee and gloom.

The eventual impact of the Great Depression and WWII on investor attitudes kept  the stock market selling at a discount until the late 1950s. By contrast, the cultural euphoria which swept the country during the baby-boom years kept stocks oscillating about a 25 percent premium between the late 1950s and the early 1970s. The stock market could be bought at a 60 to 70 percent discount in the 1970s when runaway inflation and interest rates destroyed confidence. Twenty years later in the late 1990s, investors could not buy stocks fast enough in the “new-era” even though they paid a 60 to 70 percent premium! Since 1945, two bouts of cultural glee (1960s and 1990s) subjected investors to significant risks while recurring bouts of cultural gloom have treated investors with three remarkable “fire sales”—1940s, 1970s, and “today”! Stock prices will continue to oscillate and scary sell-offs will occasionally feed fears, but don’t miss this sale!

Tags: Chief Investment Strategist, Corporate Earnings, Corporate Profits, Earnings Growth, Economic Collapse, Economic Confidence, Economic Fundamentals, Investment Climate, Lack Of Confidence, Post War, Simple Regression, Slope, Steady Revival, Stock Earnings, Stock Prices, Third Time, Trendline, Trendlines, U S Stock Market, Wells Capital Management
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Are Weak Earnings Already “Baked In”?

Tuesday, July 10th, 2012

I’ve been speaking quite a while about the difficult this earnings period could be. I’ve actually been more concerned about future guidance – Q3 and Q4 seem wildly optimistic in the context of a global slowdown, but as we get closer to the actual reporting period I’ve become concerned with the Q2 data as well. We’ve already had a flurry of high profile warnings and with both an European and Chinese slowdown, a lot of the multinational revenue growth could be in question. The stronger dollar also does not help these firms.

But the stock market is all about expectations. Many times we see a company lowball guidance or reduce expectations over the course of a quarter only to “beat” them on the day of earnings and see the stock surge. That’s just part and parcel with the Wall Street game. And I’m starting to see a lot of stories in the past 2 weeks about the potential for a bad earnings season. So has this become “baked in” at the macro level? That could be the main question to answer over the next 4 weeks.

Story 1: Reuters - Investors Brace for Shaky U.S. Earnings Season

Earnings season begins on Monday with U.S. companies facing a litany of issues that could make second-quarter reports look dismal.

Corporate outlooks are at their most negative in nearly four years and companies that have already reported have shown lackluster growth. Nearly two dozen S&P firms have already cited Europe’s woes – which seem to be worsening – as a concern.

In addition, more than 85 members of the Standard & Poor’s 500 lowered expectations in the last several weeks and the quarter’s expected earnings growth of 5.8 percent is entirely due to Apple Inc and a big earnings gain for Bank of America Corp due to a mortgage settlement last year.

Earnings growth is estimated to decline 0.4 percent without the benefit of Apple and Bank of America.

Revenue is seen up just 1.7 percent, down from 5 percent growth in the first quarter, the data showed.

Corporate outlooks are the most negative they’ve been in years. Negative-to-positive earnings guidance is now at 3.3 to 1, the worst since the fourth quarter of 2008.

Story 2: AP – Get Ready for the End of Record Corporate Profits

For almost three years, no matter what has rattled the financial markets — a debt crisis in Europe, high gasoline prices, a slower economy — investors have been soothed by rising corporate profits.

The storyline became as predictable as a soap opera’s. But when the latest round of corporate earnings starts rolling in this week, look for a twist: Profits are expected to fall.

Stock analysts expect earnings for companies in the Standard & Poor’s 500 index to decline 1 percent for April through June compared with the year before, according to S&P Capital IQ, the research arm of S&P.

That would break a streak of 10 quarters of gains that started in the final quarter of 2009.

Copyright © Market Montage

Tags: Bank Of America, Bank Of America Corp, Earnings Gain, Earnings Growth, Earnings Season, Global Slowdown, Litany, Macro Level, Outlo, Outlooks, Q3, Quarter Reports, Reuters, S 500, Season Earnings, Second Quarter, Stock Market, Stock Surge, Story 1, Street Game, Woes
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Dancing at the Edge of a Cliff (Hussman)

Sunday, May 13th, 2012

In recent weeks, I’ve emphasized that our estimate of prospective market return/risk in stocks has slipped into the most negative 0.5% of historical data (reflecting a range of horizons from 2 weeks to 18 months). Last week that estimate actually deteriorated, but I am reluctant to make comments on such a small sample, as the only more negative estimate in post-Depression history was on September 16, 2000. Even in the conditions that match the worst 2% of our return/risk estimates (which is the part of the tail we have been in since late-February), the market has lost an average of 20-25% just in the following 6-month period. As much as I try to maintain equanimity – focusing on the average outcome of a particular set of market conditions rather than the specific instance at hand – it is very difficult to do so at present.

The green bands in the chart below depict all of the points since 1980 in the neighborhood of present conditions – having a nearly similar prospective return/risk profile, coupled with a particularly hostile “exhaustion syndrome” that has been a hallmark of the worst market outcomes in recent decades. The blue line shows the S&P 500 Index. As I noted in Goat Rodeo, “what this combination picks up is an already fragile set of market internals that has enjoyed an ‘exhaustion rally’ that both exceeds earnings growth and is met with overbullish sentiment.”

I usually show longer-term charts, but there are no green bands prior to 1987. Before that point, valuations were never been as extended as they are today – on the basis of normalized earnings – except in the quarters leading up to the 1929 crash. Exhaustion syndromes prior to 1987, while still very hostile to stocks, didn’t occur in valuation conditions as rich as we have today. It’s worth noting that there is a very narrow band in 2006 that was followed by a decline of only a few percent, but even the seemingly benign instances in 1998 and early 2000 represented losses exceeding 10%. I suspect we’re at risk of something far more significant. Importantly, the drivers of our market risk estimates are largely independent of our measures of recession risk. This may provide some insight into why my concerns have become so strident in recent weeks.

Present market risks involve a confluence of factors. First, valuations remain unusually rich. Though prospective returns are better than at the 2000 and 2007 peaks, valuations remain more elevated than at any point prior to the late-1990′s bubble, save for the period before the 1929 plunge. Notably, valuations only seem “reasonable” on the basis of “forward operating earnings” if one ignores the fact that profit margins are 50-70% above historical norms, and are dependent on unsustainably large fiscal deficits and depressed household saving in order for that to continue (see Too Little to Lock In).

Second, market internals have deteriorated, with an uncomfortably familiar “two-tier” profile developing between a handful of speculative momentum stocks and the broader market. Coupled with an active new issues calendar, near-panic levels of selling by corporate insiders, heavy beta exposure among mutual funds and institutional managers, record-low mutual fund cash levels, and advisory bearishness at just 20.5% (a level last seen before the steep 2011 decline), there appears to be a lopsided exposure to risk among speculators, and a divestment among issuers.

Third, as I’ve frequently noted, the best way to extract meaningful signals and reduce noise in volatile data is to draw those signals from the joint behavior of several indicators. While these methods range from the simple to the complex, we’ve frequently presented variously defined sets of indicators (see An Angry Army of Aunt Minnies) that capture some particular investment environment (such as an overvalued, overbought, overbullish market where favorable drivers have begun to drop away). In recent weeks, we’ve seen several of these hostile syndromes emerge, as I’ve detailed in prior weekly comments.

Tags: Earnings Growth, Equanimity, Exhaustion, Goat, Hallmark, Horizons, Hussman, Instances, Market Internals, Market Outcomes, Present Conditions, Quarters, Risk Estimates, Risk Profile, Rodeo, Sentiment, September 16, Term Charts, Valuations, Worth Noting That
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Earnings Growth—Is It Enough? (Ezrati)

Monday, May 7th, 2012

by Milton Ezrati, Lord Abbett

After two-plus years of exceeding expectations, earnings this year seem poised, at last, to reflect the plodding nature of this economic recovery. In 2010 and 2011, even as the real economy managed only a paltry 2.4% average annual rate of expansion, the earnings of S&P 500^® Index¹companies soared, rising more than 47% in 2010 and almost 20% in 2011. Such a pattern could not persist. And this year, the slow fundamentals will almost surely assert themselves. Even so, it would be a mistake to read matters too pessimistically. There certainly is nothing ominous in the pattern. It is, after all, well-established historically that earnings should come into line with slower-growing revenues in this, the third year of economic recovery. Besides, this year’s probable 10% earnings growth, though only about half 2011’s pace, is sufficient to sustain the stock market rally.

This unfolding pattern of surge and moderation is hardly surprising or new. It has, in fact, become a cyclical commonplace, a reflection of the increasingly huge operating leverage of American business. Every year, business relies more and more on machinery, facilities, systems, and other forms of technology, often in place of labor. Because the trend builds a larger proportion of fixed costs into the production model, even slight variations in revenues have an exaggerated impact on the bottom line. In the more distant past, when variable labor costs were a bigger part of the overall production equation, layoffs could reduce a significant part of overall costs and so relieve some of the strain on the bottom line in recessions, and then, when rehiring raised labor costs in recovery, the profits recovery was more muted. But operating leverage has introduced a more volatile pattern.

The dramatic effect was clear during the last recession and in this recovery so far. In 2008–09, when the real economy dropped 5.1% peak to trough over 18 months, revenues followed, but because businesses had little ability to cut costs, the full brunt of the downturn fell on earnings, which, for the S&P 500, plunged from almost $22 a share in the second quarter of 2007 to a loss of more than $25 at the end of 2008. But however much strain the operating leverage imposed in the recession, it has worked in business’s favor in this recovery. As this huge array of productive capital has come back on line, the fixed costs allowed virtually all the additional revenue to fall to the bottom line. And because profits are a small difference between revenues and costs, the small percentage revenues gain have created huge percentage changes in profits. But now, in this third year of expansion, when most of this productive capital has at last become more fully utilized, the effect of operating leverage should dissipate, forcing earnings to follow slower revenues growth more faithfully.

Still, even as 2012 fails to enjoy the remarkable earnings surges of 2010 and 2011, the outlook for this year is not entirely as depressing as some media reports imply. Earnings can still outpace the 5–6% expected advance in domestic revenues because there is still some operating leverage left in the system and because S&P companies gather more than half their revenues abroad. Europe’s recession, of course, will weigh against foreign revenue growth, but the emerging economies should more than offset Europe’s depressing influence. Though these economies, too, have slowed, and that fact has attracted a lot of attention, they still outpace the United States and other developed economies by far. China, after slowing, still registers real growth of more than 8% and India more than 6%. In nominal terms (which, of course, is the way revenues are measured), those economies should still contribute double-digit growth of their part of the 2012 S&P revenues equation. Adding to likely 7–8% overall revenues gains, the remains of operating leverage should bring S&P earnings up to about 10% in 2012.

That growth, though half last year’s pace, should nonetheless allow equity markets to hold the gains they have already made and likely rise further. Even after market gains of the last six months, valuation measures are far from stretched. Price-to-earnings multiples, after all, depending on which of the seemingly endless calculations one chooses, show a market that at worst is near its historical valuation benchmark, allowing it room to keep up with earnings at least. Since, in most other respects, valuations are still more attractive, equity price advances should exceed the earnings growth. Stocks, relative to Treasury bonds, offer valuations not seen since the early 1950s or even the Great Depression. Next to corporate bond yields, equity valuations look less dramatic, but still suggest considerable upside potential. It is noteworthy that, even today, dividend yields on many stocks atypically exceed the yields on the firm’s own bonds.

Since earnings, though slowing, are still showing substantive growth, the most conservative interpretation of valuations would suggest that equities should hold this year’s gains so far. Anything other than the most conservative interpretation suggests greater gains.

¹The S&P 500^® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.

Tags: American Business, Bottom Line, Commonplace, Dramatic Effect, Earnings Growth, Economic Recovery, Forms Of Technology, Layoffs, Lord Abbett, Market Rally, Milton Ezrati, Moderation, Operating Leverage, Production Model, Proportion, Recession, Recessions, Reflection, Stock Market, Trough
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Late Bull Stampede Turns Bears Into April Fools (Coté)

Monday, May 7th, 2012

by Douglas Coté, Chief Investment Strategist, ING Investment Management

The bears grew hopeful early in the month, as global markets were spooked by goings-on in the euro zone: Spain briefly brought back fears of bailout Armageddon, the Dutch government collapsed, and PMI numbers for the region came in weaker than expected. April Fools! The bull market remains intact and offers compelling value for those looking to build wealth.

At its April trough, the S&P 500 was down 3.5% for the month. However, the bull awoke mid-April, prodded by relentless corporate strength that continues to confound Wall Street. Blockbuster corporate profits were led by financials, followed by industrials and put over the top by technology. With a meager 0.89% consensus expectation for first quarter earnings growth, Wall Street got it wrong; in fact, considering that first quarter earnings growth, at press time, stands at an explosive 8.8%, “got it wrong” is a serious understatement. The S&P 500 surged into the end of the month, making up nearly all its lost ground.

This performance is no joke for those who are missing out on an extraordinary bull market that has just entered its fourth year. It is not too late for savers to turn into investors, but this market’s persistent and determined march forward will not wait for the hesitant. Investors must resist the all-ornothing approach to risk; a moderate risk posture has been handsomely rewarded over the past three years despite pockets of extreme volatility.

The questions for investors to ask are how and when to invest. We get into the “how” below. The answer to “when” is more straightforward — immediately! Don’t delay, because every day is a good day to invest during a bull market.

ING Global Perspectives Monthly Commentary May 2012

Tags: April Fools, Armageddon, Bailout, Blockbuster, Chief Investment Strategist, Corporate Profits, Corporate Strength, Dutch Government, Earnings Growth, Euro Zone, Extreme Volatility, Fourth Year, Global Markets, Global Perspectives, Industrials, Ing Investment Management, Moderate Risk, Press Time, Quarter Earnings, Stampede
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Apple’s Growth Scorecard for the first quarter of 2012

Wednesday, April 25th, 2012

For Apple 2012 started with almost the same growth as 2011 started. Q1 2011 saw earnings growth of 92% and Q1 2012 saw growth of 94%. As the following revenue growth table shows, the pattern for the last twelve months has been very consistent:

Here are some notes:

• The iPad is growing at a faster rate than the iPhone and has achieved in two years what the iPhone took four.
• The iPhone grew units at nearly 90% and revenues at 85%. This is slightly below the quarterly average over the last two years of 99%
• The Mac showed significant weakness though the previous year’s Q1 had exceptionally high growth of 32%. The Mac still grew faster than the market and therefore gained share
• The iPod is declining consistently. Units showed a lesser decline than revenues as the average price dropped from $164 to $157.
• The iTunes store continues to grow very rapidly, reaching a new record level above $2.1 billion revenues
• Peripherals were weak with 11% growth but that may have something to do with lowered Mac sales
• Software had good quarter though not exceptional
• The top line grew at nearly 60% which is not exceptional but the bottom line grew at 94% which is above average

Overall, the company had a very good quarter and showed consistency, which, incidentally, implies predictability. The following graph shows the top and bottom lines in historical context with color coding matching the table above.

Tags: Bottom Line, Bottom Lines, Color Coding, Consistency, Earnings Growth, First Quarter, Graph, Historical Context, Ipad, Iphone, Itunes, Mac Sales, Peripherals, Predictability, Previous Year, Q1, Sales Software, Scorecard, Twelve Months
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Q2 Markets: Don’t Expect Smooth Sailing

Wednesday, April 18th, 2012

by Russ Koesterich, iShares

After a disappointing, frustrating and, at times, terrifying 2011, patient investors were rewarded with a stellar start to 2012. In the first quarter, equity markets banked a performance that would have been respectable for the full year. Developed markets gained nearly 11%, while emerging markets advanced more than 13%. However, equity markets have lost some steam in recent days, and now many investors are wondering if there’s anything to look forward to in the second quarter.

The good news is that even after the rally, valuations still appear reasonable. Developed markets are currently trading at around 14x earnings, no longer a screaming bargain but below historic averages. Emerging markets, meanwhile, are even cheaper, trading at less than 12x trailing earnings. In addition, inflationary pressures remain well contained and while last Friday’s disappointing employment report reminded everyone that the recovery will continue to be slow and uneven, both the US and global economies are stabilizing.

That said, I don’t expect markets in the second quarter to be all smooth sailing. While markets can still move higher, gains are likely to be predicated on earnings growth, which in turn will depend on further improvement in the global economy. And even if the economy continues to stabilize, we’re unlikely to see another round of quantitative easing until at least July as the Fed’s Operation Twist is set to continue through June.

Without the sedative of easier monetary policy, markets are likely to be more volatile. I expect volatility to be in the high teens to low 20s, above the mid-teen levels that characterized the first quarter. In fact, it’s probably fair to say that the first quarter rally was more a function of continuing, and arguably intensifying, central bank generosity rather than a reflection of fundamentals experiencing a complete turnaround.

Given this environment, as the second quarter kicks off, investors should consider repositioning their portfolios to access international equity income, prepare for more volatility and shift into investment grade credit.

As I’ve mentioned before, in an environment of slow growth and more volatility, higher income stocks are more likely to outperform. However, such stocks currently look expensive in the United States, meaning investors may want to cast a wider net to get their dividend exposure through vehicles such as the iShares Dow Jones International Select Dividend Index Fund (NYSEARCA: IDV) and the iShares Emerging Markets Dividend Index Fund (NYSEARCA: DVYE).

In addition, as the market becomes more volatile, investors may want to consider equity funds that employ a minimum volatility methodology that can potentially help insulate portfolios from wild market swings. Such funds typically hold lower-beta stocks than similar, cap-weighted benchmarks and have historically produced higher risk-adjusted returns over the long-term.

Finally, as I wrote earlier this month, while high yield can still offer a good coupon, investment grade debt, accessible through the iShares iBoxx $ Investment Grade Corporate Bond Fund (NYSEARCA: LQD), looks cheaper and should hold up better during a more volatile quarter.

Source: Bloomberg

The author is long LQD and IDV

International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. There is no guarantee that dividends will be paid.

Minimum volatility funds may experience more than minimum volatility as there is no guarantee that the underlying index’s strategy of seeking to lower volatility will be successful.

Bonds and bond funds will decrease in value as interest rates rise.

Past performance does not guarantee future results.

Tags: Asset Allocation, Columbia Management, Credit Crisis, Diversification, Earnings Growth, Emerging Markets, Employment Report, Financial Situation, First Quarter, Generosity, Global Economies, Global Economy, Inflationary Pressures, Investment Advisers, Investment Mix, Iranian Hostage Crisis, Ishares, Last Friday, Market Crash Of 1987, Market Fluctuations, Monetary Policy, Ned Davis Research, Patient Investors, Portfolio Holdings, Q2, Quarter Rally, Rebalancing, Reflection, Risk And Reward, Risk Tolerance, Russ, Second Quarter, Sedative, Smooth Sailing, Stock Market Crash, Stock Market Crash Of 1987, Substantial Market, Time Horizon, Turnaround, Valuations, Volatility, Weather Market
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